20 years of accurate predictions on China and the world economy
实事求是 - seek truth from facts, Chinese saying originally from the Han dynasty

10 February 2014

'Market romanticism' is as damaging in China as everywhere else

China is by now strong enough to deal with any external threat to its development. Only major internal errors can block its progress. One well known such threat is any attempt to return to an administered, as opposed to a ‘socialist market’, economy. However negative financial events – increases in interbank lending rates, falls in share prices, much higher bond yields than in other major economies, falls in manufacturing and service sector PMIs - highlight another danger, that of ‘market romanticism’ as opposed to ‘market realism’. This consists of verbally adhering to a ‘market economy’ but in fact not understanding what a market economy is. Put formally, market romanticism is simply the economics of neo-liberalism.

Various negative trends which have shown themselves in China’s economy in the immediate last period in reality have a clear and simple market origin. As shown in the chart China’s total savings rate has significantly fallen from 53.2% of GDP in 2009 to 51.4% of GDP in 2012 – it is important to note that total savings are not only those of households but also company savings and the ‘negative savings’ of the government budget deficit. Total savings data is not yet published for 2013 but there is no indirect data, in particular for company profits, showing a major recovery in savings rates.

This decline in China’s savings rate has as consequences rising interest rates, a decline in investment, and therefore economic slowdown – tendencies at present expressing themselves.

Interest rates are the price of capital and express the balance between capital supply (savings) and demand for capital (investment). As savings rates have significantly fallen one of two things must occur – or both. Either interest rates must rise, as the supply of capital has fallen relative to demand, or investment, the demand for capital, must decline.

As frequently occurs, both trends are taking place in China. Demand for capital, that is investment, is slowing – a trend augmented by rising interest rates. Taking a three year moving average, to eliminate effects of purely short term fluctuations, the chart below shows that by 2012 the real inflation adjusted growth rate of China’s fixed investment fell to the lowest since 2001 at 9.9%.

Inflation adjusted data for investment in 2013 is not yet published, but current price data shows the annual increase in fixed asset investment fell from 21.2% in January 2013 to only 19.9% in the latest available data. As there has been no corresponding fall in inflation it is almost certain that the real rate of increase of fixed investment fell further in 2013.

Simultaneously with falling investment China’s interest rates have risen. This was partially disguised in 2012 as inflation was declining – therefore real interest rates could rise without the headline grabbing nominal rate increasing. But as China’s inflation ceased falling in 2013 nominal rates began to rise significantly.

The result is that not only have China’s interest rates risen in absolute terms, as shown in both bond and interbank lending markets, but they have particularly risen relative to the global benchmark US rates – US savings levels, in contrast to China, have been rising for the last four years. At the beginning of 2008 the yield on China’s 10 year government bond yields was only 0.5% higher than the US, whereas by the 2nd week in January 2014 it was 1.9% higher. The sharp spikes in interbank interest rates last summer, and again late last year, were manifestations of the same process of rising interest rates.

With China’s growth rates falling, and interest rates rising, the recent fall in the share market was logical.

A slowing rate of investment and rising interest rates necessarily produces slows economic growth and therefore more slowly rising living standards – as the rate of increase of GDP is overwhelmingly the most important source of rising consumption. China’s GDP growth fell from 9.3% in 2011 to 7.7% in 2012, and its growth rate of consumption fell in parallel from 10.7% to 8.4%. Again inflation adjusted data for 2013 is not yet available, but without adjusting for inflation the rate of increase of retail sales fell from 14.9% in November 2012 to 13.7% in the same month in 2013. As in the same period the rate of increase of the CPI rose from 2.0% to 3.0% almost certainly the growth rate of consumption was falling.

These problems were accurately predicted in advance. A falling savings rate is merely another way of saying that the percentage of consumption in the economy is rising – that is ‘consumption led growth’ is occurring. But predictably such a rise in the percentage of consumption in the economy is making the situation worse not better.

Understanding how a market economy works equally shows the only way to strategically overcome these problems. That as a country becomes more economically advanced capital investment plays a larger role in its growth is both confirmed by modern econometrics and predicted by the great economists from Adam Smith onwards – in an advanced economy investment’s role is six times as important as productivity increases in economic growth, with 57% of growth coming from investment, and only 9% from productivity improvements. But without foreign borrowing investment requires exactly equivalent domestic saving.

The only strategic way to deal with present economic problems is therefore to raise the savings rate again –which will simultaneously allow a faster growth rate of investment and, by increasing the supply of capital, allow interest rates to fall, thereby lessening problems in the interbank and bond markets. As the largest contributor to savings comes from companies, this therefore requires increasing company profitability and limiting the diversion of company profits to consumption (via excessive dividend payment or other means).

The factual arithmetic of a market economy therefore requires understands that maintaining a high level of savings and investment is the single biggest challenging facing China’s development and all policies, including in finance, must therefore be aimed at sustaining it.

‘Market romanticism’, because it does not understand the facts of a market economy, wrongly believes productivity increases, achieved via tinkering with markets, can compensate for a fall in China’s savings and investment rates. It is ‘penny wise and pound foolish’ - concentrating on hoped for efficiency improvements which even if they were successful could not compensate for falls in savings and investment.

‘Market realism’ and ‘market romanticism’ are therefore clashing in the present economic situation in China. ‘Market realism’ concentrates on the key fact of the necessity to maintain the high savings and investment rates – increased market efficiency is useful but cannot compensate for problems in these more fundamental economic factors. ‘Market romanticism’ wrongly believes that increased efficiency in markets can compensate for declines in the savings rate or even advocates policies which would reduce the savings level further.

But as is said in the West ‘facts are stubborn things.’ Carrying out policies of ‘market romanticism’ necessarily produces financial and economic problems.

Developing a ‘socialist market economy’ is the way forward for China, and return to an administered economy would be disastrous. But as recent negative financial trends confirm it is necessary to reject the myths of ‘market romanticism’ to develop such an economy.

* * *

An edited version of this article appeared originally in Chinese in a series of discussion articles on the market economy on Sina Finance.